Why Selling Apple Puts Beats Buying the Stock

There are lots of reasons to prefer selling puts on something rather than buying it outright, not the least of which is that you have a bit of a cushion when you write out-of-the-money puts rather than buying the underlying entity. But in the case of a big meltdown, which we are witnessing today in Apple (AAPL), the edge goes to the put writer by a considerable margin. Here's what I mean.

This morning, the stock opened right at $460. Then over the next 15 minutes or so, it sold off almost another 10 points to its current almost-12-month low of $450.66. From there it bounced back up 15 points to the morning highs of $465.73, and then it was back down again.

So far (as of 2 p.m. Eastern time), it's still holding narrowly above the morning lows. Any way you slice it, the stock is getting massacred, currently off 61 points (almost 12%) to the $453 level. And for that matter, it's trading well below the opening at $460. So anyone who figured it was a safe play at the opening as it collapsed to almost-12-month lows now has a 7-point loss in the stock.

But how about the option writer? By contrast, the out-of-the-money puts are generally pretty close to levels seen at the opening, even though the stock is lower. This is simply because option buyers panic in a situation like this and bid up puts on the opening as if the stock is going straight down to $400. No bounces, no respite from the nonstop selling, just a straight drop of 100 points or more to the next century mark.

Granted, that kind of thing can happen, but it rarely does. Things get overdone, and puts fall in that category, more so than stocks and more than calls. Puts are the safety net for millions of holders of anything and everything. Puts are the last resort, the one thing that panicky holders can always count on. So people buy them in times of panic, and within an hour or so, they usually wish they hadn't.

Such was the case with Apple puts this morning. Take a look at the action in the March 410 puts, which I was busy writing this morning while the stock was near the $458 level in the first two minutes of trading. I began selling them at $4.75 and sold some more at $5.00 and more at $5.55. The puts peaked at $5.80, probably at about the same time the stock was bottoming just above $450.

Then, as the stock bounced, the puts collapsed – these March 410s giving up almost two-thirds of their gain (back to a low of $3.75) as the stock bounced back 15 points, which was less than one-quarter of its drop.

You see the problem here? On a marginal bounce of less than a quarter of the drop in the stock, the March 410 puts gave up more than half of their gain. That's one reason I prefer being an option writer -- if I can take advantage of a big collapse in the stock.

Of course, the flip side of that is that you don't really want to already be in a big short put position before a big drop in the stock, or you can get yourself killed. A simple rule of thumb is, if you are not prepared to take delivery of the stock (100 shares per option), then you probably shouldn't be writing those puts. The biggest pitfall I see traders get into, especially novice traders, is taking on too much exposure in these things and being all tied up in front of some big announcement of the sort we had yesterday.

Fortunately, I had covered or hedged all of my short February puts, so I was in a pretty good position to take advantage of a big shakeout in the stock this morning. If I had been leveraged to the eyeballs, holding short a bunch of out-of-the-money March puts in front of the news, I wouldn't have been in position to do much of anything -- except scream. So, with this stuff, timing really is everything.

So where should the stock go from here? Well, I am hearing all kinds of awful projections from $425 down to $350 or even $300. I don't think I've heard anyone say it's headed to $200 yet, but we probably will hear that as well. The chart below details one way of looking at the stock as it highlights my favorite things: gaps.

In this chart, note that today's big gap-down opening created in its wake not just one or two but three bearish island reversals. Yes, three. The first one, closest to current levels, is from way back on last Feb. 8. That day, the stock gapped up from $468.83 and left a gap to $469.70. That gap has now been converted to a bearish island, as the stock gapped through that prior gap this morning on the opening. That's the first one, and I suspect it won't be too tough for the stock to knock out.

Then there is the one from Feb. 9. This one is more sizable, from $476.68 to $480.56. This could be a bit more of a challenge. Finally, there is the one that is the result of the recently created gap from Jan. 16 at $485.92-$492.50. That's the third island. That could be a bit of a struggle for the stock, but I would still expect this third island to be aborted in the weeks ahead. After that, sledding on the upside will be tougher, and I wouldn't be surprised to see the island aborted at $492.50 but see today's massive gap up to $514 to remain partially unfilled.

On the downside, there are lots of possible targets, but my preferred target is the bottom of the big gap from a year ago. It was actually formed on Jan. 25 of last year, and the gap is based on the Jan. 24 close of $420.41 and goes to the Jan. 26 low of $443.14. Note all the consecutive lows right at the $443 level. That is next support if the morning lows give way. Then the bottom of the gap is at $420.41. That could be worst case, at least for the near term.

The bottom line for me with Apple is that I don't mind writing the distant March puts in here with the stock hovering above $450, at least for a trade, but I am still not a buyer of the stock. Not here. Not yet. Along similar lines, I am also writing the out-of-the-money March 64 puts in the PowerShares QQQ (QQQ).